Answers

Professional Level – Options Module, Paper P7 (UK)Advanced Audit and Assurance (United Kingdom) December 2008 Answers

1 Bluebell Ltd

(a) Financial Statement Risks

Revenue RecognitionBluebell Ltd has an accounting policy of recognising revenue when a room is occupied. The deposits (and possibly sometimeseven full payment) are received when the room is booked. Turnover will be overstated if it is recognised too early. On receiptof a deposit prior to the occupation of the room, the revenue should be deferred and disclosed as a liability, per FRS 5Application Note G – Revenue recognition. Liabilities may therefore be understated and profit overstated.

Further indication of possible overstatement of revenue is shown by Bluebell Ltd’s 24·8% increase in revenue compared tothe industry average of only 20%.

Share-based paymentThe expense could be overstated if the assumption regarding all of the shares vesting is incorrect. The expense should becalculated by considering whether performance conditions attached to the share options will be met. It is unlikely that everysingle employee granted an option will meet the required performance criteria and therefore a more realistic, lower estimateshould be made of the expense. The expense should be adjusted each year end to account for staff turnover. If the expenseis overstated due to an incorrect assumption, then the corresponding credit to equity is also overstated.

In addition, the calculation of the total cost of the share-based payment is complex, and if any of the components of thecalculation are incorrect, then the expense will be over or understated. For example, the fair value used to calculate theexpense should be the fair value of the granted share options calculated at the grant date – the use of fair value at any otherdate is incorrect. The model used to calculate fair value (e.g. the Black-Scholes Model) must comply with FRS 20 Share-based payment.

It is also important for the measurement of the expense that it has been calculated based on the share options being grantedmidway through the accounting period.

ProvisionsThe provisions for repairing flood damage should only be recognised if Bluebell Ltd has an obligation to perform the repairsat the year end. There is unlikely to be any legal or constructive obligation attached to this situation so a provision should nothave been recognised in this accounting period. Operating expenses (and tangible fixed assets if any portion of the provisionrelating to refurbishment has been capitalised) and liabilities are therefore overstated.

Disclosure should be made in a note to the financial statements for any capital commitment entered into before the year end.

In addition, it is important to consider that the buildings are covered by an insurance policy, which will pay out for repair andrefurbishment costs to the assets. The fact that Bluebell Ltd has recognised a repair expense of £100 million indicates thateither the buildings were not covered by adequate insurance (a business risk), or that the accounting implication of thereimbursement has been ignored.

Tutorial note: Credit will be awarded for alternative interpretations as to whether an obligation exists at the year end for theproperty repairs to be carried out.

Impairment of flood damaged propertiesThe net book value of the properties will be overstated if the carrying value has not been fully written down to recoverableamount. It is not stated whether or not the damaged properties have been tested for impairment, but it would seem likely,given the amount of damage caused by flooding, that some impairment loss should have been recognised this year.

Potential understatement of operating expensesA comparison of operating expenses for the two years reveals an unusual trend. The operating expenses for 2008 include twonew items – the share-based payment expense of £138 million, and the repairs of £100 million. Once these have beeneliminated to enable a meaningful comparison to the previous year, the 2008 operating expenses are £597 million (£835 –138 – 100). This is a reduction in operating expenses compared to the prior year of £93 million i.e. 13·5 % (93/690 x 100).

Given that revenue has increased by 24·8% (as discussed above), it would appear likely that operating expenses for thecurrent year are understated.

Property disposalsThe profit on disposal should have been separately disclosed on the face of the profit and loss account as an exceptional itemper FRS 3 Reporting financial performance. Including the amount within other operating income is incorrect disclosure.

However, it appears that the substance of this transaction is more a financing arrangement than a genuine sale. Bluebell Ltdhas retained operational control of the assets and is still exposed to the risk and the reward associated with the properties,as shown by the financial return received each year based on the performance of the hotels. In addition, the option torepurchase in 15 years time indicates that at that time Bluebell Ltd will be repaying the long-term finance secured on theproperties ‘sold’.

Therefore the assets should remain on the balance sheet, with the proceeds received on the ‘sale’ recognised as a liability.There should be no profit recorded on the transaction. Currently other operating income is overstated by the ‘profit’ of £125 million. Tangible fixed assets are understated by the value of the properties ‘sold’, and liabilities understated by theamount of finance raised.

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In addition, Bluebell Ltd will need to continue to depreciate the properties. Operating expenses are currently understated dueto the lack of depreciation on the disposed properties since the date of disposal.

Finally, as the ‘sale’ is in reality a finance arrangement, it is likely that Bluebell Ltd should accrue finance charges. The totalfinance charge associated with the sale and repurchase arrangement should be allocated over the period of the finance. It islikely that finance charges are understated due to the lack of inclusion of finance cost in relation to the sale and repurchasearrangement.

Property revaluationsTangible fixed assets is a highly material figure, representing 44% of total assets (2007 – 51%). The revaluation during theyear introduces financial statement risk to the carrying value of the assets given the subjective nature of establishing the fairvalue of properties. As Bluebell Ltd is trying to raise finance in order to improve liquidity, there is a definite incentive forovervaluation of the properties, as this will strengthen the balance sheet and make Bluebell Ltd more attractive to potentialproviders of finance.

Under FRS 19 Deferred tax, a deferred tax provision should not be recognised on the revaluation of a property, unless thereis a binding commitment at the year end to sell the property. Note 6 shows a deferred tax entry of £88 million charged toequity during the year in respect of tangible fixed assets, representing 35·2% of the £250million revaluation gain recognised(note 4). Therefore it would seem that Bluebell Ltd has incorrectly recognised a deferred tax provision on the revaluation gain,in breach of FRS 19. The financial statements are misstated, with the deferred tax provision overstated, and equityunderstated by £88 million.

Deferred tax assetFRS 19 states that a deferred tax asset in relation to unutilised tax losses can only be recognised where there is persuasiveand reliable evidence suggesting that suitable taxable profits will be generated in the future. Unutilised tax losses can becarried forward for offset against future taxable profits, so Bluebell Ltd must demonstrate, using budgets and forecasts, thatfuture tax profits will be available for the losses to be fully utilised. If this cannot be demonstrated then the deferred tax assetrecognised should be restricted to the level of future profits that can be measured with reasonable certainty.

The financial statements currently show a profit before tax of £145million, indicating healthy performance. However, whenthe profit on asset disposal is removed from the profit and loss account, if adjustments are necessary in respect of the impairedproperties (as discussed above), and if finance costs and depreciation charges need to be expensed in respect of the sale andrepurchase agreement, then it could be that Bluebell Ltd’s profitability has actually substantially decreased from last year, andis likely to be a loss.

Tutorial note: credit will be awarded where candidates calculate a new profit before tax figure based on the adjustmentssuggested in their answer.

Given this detrimental underlying trend in profitability, and given the past losses generated by the company, it could be difficultto demonstrate that the tax losses are recoverable against future profits. If this is the case then the deferred tax asset isoverstated.

Going concernGiven poor liquidity, and an underlying trend of falling profits, the company could face going concern problems. Disclosureregarding the availability of long-term finance may be necessary for the financial statements to show a true and fair view.

(b) (i) Principal audit procedures – measurement of share-based payment expense

– Obtain management calculation of the expense and agree the following from the calculation to the contractualterms of the scheme:

– Number of employees and executives granted options– Number of options granted per employee– The official grant date of the share options– Vesting period for the scheme– Required performance conditions attached to the options.

– Recalculate the expense and check that the fair value has been correctly spread over the stated vesting period.

– Agree fair value of share options to specialist’s report and calculation, and evaluate whether the specialist report isa reliable source of evidence.

– Agree that the fair value calculated is at the grant date

Tutorial note: A specialist such as a chartered financial analyst would commonly be used to calculate the fairvalue of non-traded share options at the grant date, using models such as the Black-Scholes Model.

– Obtain and review a forecast of staffing levels or employee turnover rates for the duration of the vesting period, andscrutinise the assumptions used to predict level of staff turnover.

– Discuss previous levels of staff turnover with a representative of the human resources department and query why0% staff turnover has been predicted for the next three years.

– Check the sensitivity of the calculations to a change in the assumptions used in the valuation, focusing on theassumption of 0% staff turnover.

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– Obtain written representation from management confirming that the assumptions used in measuring the expenseare reasonable.

Tutorial note: A high degree of scepticism must be used by the auditor when conducting the final three proceduresdue to the management assumption of 0% staff turnover during the vesting period.

(ii) Principal audit procedures – recoverability of deferred tax asset

– Obtain a copy of Bluebell Ltd’s current tax computation and deferred tax calculations and agree figures to anyrelevant tax correspondence and/or underlying accounting records.

– Develop an independent expectation of the estimate to corroborate the reasonableness of management’s estimate.

– Obtain forecasts of profitability and agree that there is sufficient forecast taxable profit available for the losses to beoffset against. Evaluate the assumptions used in the forecast against business understanding. In particular considerassumptions regarding the growth rate of taxable profit in light of the underlying detrimental trend in profit beforetax.

– Assess the time period it will take to generate sufficient profits to utilise the tax losses. If it is going to take a numberof years to generate such profits, it may be that the recognition of the asset should be restricted.

– Using tax correspondence, verify that there is no restriction on the ability of Bluebell Ltd to carry the losses forwardand to use the losses against future taxable profits.

Tutorial note: Losses can normally only be carried forward to be utilised against profits generated from the sametrade. Although in the scenario there is no evidence of such a change in trade, or indeed any kind of restrictionon the use of losses, it is still a valid audit procedure to verify that this is the case.

(c) Briefing notesGuidance on the establishment of social and environmental Key Performance Indicators (KPIs) within Bluebell Ltd

For discussion with Daisy Rosepetal, internal auditor of Bluebell Ltd

IntroductionMany companies use social and environmental KPIs as a means of establishing performance targets and measuring resultsagainst that target. Social KPIs involve performance relating to employees, customers, and the wider community.Environmental KPIs are focused on the environmental impact of the company’s activities.

The following table recommends some KPIs and suggests the evidence that should be available in relation to each KPI:

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KPI Nature of evidence

Social – employees

% female employees, % ethnic minority employees. Personnel files, starters’ and leavers’ documentation.

Staff absentee rates – number of days of absenteeismcompared to total labour days per year.

Payroll records, medical certificates supporting sick leave.

Employee satisfaction/engagement index. Internal audit could prepare a questionnaire/survey ofBluebell Ltd’s staff. Alternatively summaries of staff appraisalrecords could provide evidence.

Monetary value of staff training and development. Cash book to verify amount. Also documents authorising thetraining and outlining the need for the training.

Staff turnover Personnel files, leavers’ documentation from payroll records,exit interview records.

Social – customers

Customer satisfaction rates – % satisfaction with serviceprovided, cleanliness of room, quality of food, etc.

Surveys or questionnaires completed by customers afterstaying at a hotel or using a room for an event.

Level of repeat bookings – repeat bookings as % of totalbookings.

Customer account details from the sales system wouldindicate multiple bookings. Bluebell Ltd may operate aloyalty reward scheme to attract multiple bookings – thiswould provide detailed evidence.

Level of complaints – number of customers who havedemanded refunds or have made a formal written complaint.

Management log book of complaints received. Sales systemcould provide evidence of refunds via credit notes issued.

Number of customers reporting accidents while on BluebellLtd premises (this point could also be made in relation tostaff).

Accident log book describing the nature of the injury,seriousness, whether emergency services called.

ConclusionThe specific KPIs set by Bluebell Ltd should reflect the priorities of the company. There is an extremely wide range of measuresthat could be used – the important thing is to make each measure quantifiable and to ensure that evidence will be readilyavailable to support the stated KPI. In the absence of this, the KPIs may lack credibility if disclosed in the future as part ofBluebell Ltd’s annual report or in any publicly available information.

Tutorial note: The answer states more than the required number of KPIs to illustrate the wide variety of points that couldhave been made in answering the question. As indicated in the conclusion to the briefing notes, there are many alternativeKPIs which could have been suggested for use by Bluebell Ltd. Credit will be awarded for any suitable KPI and associatedevidence.

2 Crocus Ltd

(a) (i) Forensic accounting utilises accounting, auditing, and investigative skills to conduct an examination into a company’sfinancial statements. The aim of forensic accounting is to provide an accounting analysis that is potentially suitable foruse in court. Forensic accounting is an umbrella term encompassing both forensic investigations and forensic audits. Itincludes the audit of financial information to prove or disprove a fraud, the interview process used during aninvestigation, and the act of serving as an expert witness.

Tutorial note: Forensic accounting can be used in a very wide range of situations, e.g. settling monetary disputes inrelation to a business closure, marriage break up, insurance claim, etc. Credit will be awarded for any reasonableexamples provided.

(ii) A forensic investigation is a process whereby a forensic accountant carries out procedures to gather evidence, whichcould ultimately be used in legal proceedings or to settle disputes. This could include, for example, an investigation intomoney laundering. A forensic investigation involves many stages (similar to an audit), including planning, evidencegathering, quality control reviews, and finally results in the production of a report.

(iii) Forensic auditing is the specific use of audit procedures within a forensic investigation to find facts and gather evidence,usually focused on the quantification of a financial loss. This could include, for example, the use of analyticalprocedures, and substantive procedures to determine the amount of an insurance claim.

(b) Report to Gita ThralesSubject: Forensic investigation into alleged payroll fraud

IntroductionThis report has been requested in order to outline and explain the operation of a forensic investigation into an alleged payrollfraud. The report will outline the steps taken in such an investigation and provide an explanation of the expected output ofthe work performed.

Objectives of a forensic investigationThe first objective is to decide if a deliberate fraud with the intention of stealing cash from the company has actually takenplace. There is a possibility that the employees made redundant have remained on the payroll records by error rather than

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Social – wider community

Monetary value of any donations made to local or othercharities, could be expressed as % of profit.

Cash book will show value of any donations. Board minutesshould contain evidence of authorisation.

Number of times Bluebell Ltd has made its hotels availablefor use free of charge for local community or charity events.

Register of events – Bluebell Ltd will have some kind of diaryor timetable indicating date and reason for use of facilities.Approval by manager of free use.

Environmental

% change in water use, electricity use, etc compared to prioryear.

Comparison of utilities costs using suppliers bills received.Review of actual to budgeted consumption of water,electricity, etc.

Monetary amount of investment in or purchase ofenvironmentally friendly items, e.g. energy efficient lightbulbs, recycled paper, water efficient dishwashers.

List of preferred suppliers and products. Observation byinternal auditor of products used in the hotels.

Quantification of carbon footprint, and % change from prioryears.

Review energy supplier contracts for evidence that energyused is from renewable sources. Board authorisation of anypayments made for carbon offsetting.

% waste recycled compared to non-recycled. Cash book should show amounts invested in recyclingfacilities at each hotel. Observation of the use of recyclingfacilities.

fraud. The investigation should uncover whether the situation has arisen through mistake or through deliberate criminalaction.

Secondly, the investigation will aim to discover the perpetrator(s) of the fraud, and ultimately to assist in their prosecution.The investigation will gather evidence, which may include an interview with the suspected fraudster, which can then be usedin criminal procedures against the individual(s) concerned. In this case there is an individual suspected of involvement in thealleged fraud. It will be an important part of the investigation to discover if there were other people involved, as frauds ofteninvolve collusion between several individuals.

Thirdly, the investigation should quantify the financial loss suffered by Crocus Ltd as a result of the fraud. The evidencegathered will determine the amount which has been stolen from the company as a result of the fraud. It is important for theloss to be quantified, as legally a crime has only been committed if a victim (i.e. Crocus Ltd) has suffered a financial loss.

Steps in investigating a suspected fraudThe first step will be to determine the type of fraud that has taken place. The fact that employees no longer employed by thecompany have not been removed from the payroll indicates a fraud known as a ‘ghost employee’ scheme, whereby thefraudster diverts the payroll of the non-existent employees into their own possession.

Then the investigator will need to consider how the fraud could have taken place. This would normally be due to thefraudster(s) circumventing internal controls and concealing their actions from their colleagues and supervisors. For example,there should be a control in place to ensure that any amendments made to payroll data (in this case an amendment appearsto have been made to re-route the ex-employees’ pay into the bank account of the fraudster) must be approved by a seniormanager, and should be flagged by an exception report.

The investigator will also need to establish how long the fraud has been operating – in this case it is likely that the fraudbegan at the same time as the factory closure, but this will need to be clarified.

The next step would be to gather evidence – this is a crucial part of the investigation as it should determine both the identityof the perpetrator(s) and the monetary value of the fraud. Gathering evidence could include an examination of accountingrecords and other documentation, the use of computer-assisted auditing techniques (CAATs), interviewing employees of thecompany, and discussions with management. A key issue here is to ensure that the evidence will be sufficient to prove threematters:

– That a fraud has taken place,– The identity of the fraudster, and– The amount of the loss to the company.

This is essential because the legal framework will require clear evidence in order for a prosecution to be instigated against theperpetrator(s) of the fraud.

Evidence must be sufficient and relevant to the accusations being made. For example, the legal framework is likely to requireevidence of the following:

– The motive for the fraud,– The ability of the alleged fraudster to conduct the fraud, and– Any attempt made by the alleged to conceal the crime.

Investigative procedures could include, for example:

– Review of authorisation of monthly payroll.– Use of CAATs to determine any alteration of payroll details.– Use of CAATs to determine:

– Any individual on the payroll who has no contact details.– Any bank account receiving the pay of more than one individual.– Employees who have not taken holiday or sick leave.

– Reconciliation of employees in the payroll database with employees in the human resources database.

The purpose of the above is to establish how the controls that should have been operating in the payroll system werecircumvented. It would seem that authorisations to alter payroll details, i.e. altering payments so that they all go into one bankaccount, have not taken place.

The investigation should also involve an interview with the suspect(s), with the aim of extracting a confession. This wouldform a key part of the evidence to be ultimately presented at court.

The investigator will produce a report for the attention of the management of Crocus Ltd, summarising all findings andconcluding on the identity of the fraudster(s) and the amount of financial loss suffered. This report is also likely to be presentedas part of evidence during court proceedings.

Though not strictly part of the investigation, which ends on the production of the report described above, it is worthmentioning that the investigator would be likely to be called as an expert witness during the legal process, whereby theevidence gathered and report produced as part of the investigation would be explained to those involved in the legalproceedings, and the investigator may be asked questions regarding the investigation performed.

Finally, advice can be provided to management, as to how to prevent this kind of fraud from occurring again.Recommendations would be likely to focus on improvements in internal systems and controls in the specific part of thebusiness where the fraud occurred.

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ConclusionThis report has explained that the objective of a forensic investigation is to clarify whether a fraud has taken place, to discoverthe identity of the fraudster, and to quantify the financial loss suffered. The specialist skills of the investigation team willproduce evidence which is sufficient and relevant enough to be used to assist legal proceedings against those involved withthe fraud.

(c) Application of ethical principles to a fraud investigationIFAC’s Code of Ethics for Professional Accountants applies to all ACCA members involved in professional assignments,including forensic investigations. There are specific considerations in the application of each of the principles in providingsuch a service.

IntegrityThe forensic investigator is likely to deal frequently with individuals who lack integrity, are dishonest, and attempt to concealthe true facts from the investigator. It is imperative that the investigator recognises this, and acts with impeccable integritythroughout the whole investigation.

ObjectivityAs in an audit engagement, the investigator’s objectivity must be beyond question. The report that is the outcome of theforensic investigation must be perceived as independent, as it forms part of the legal evidence presented at court. Theinvestigator must adhere to the concept that the overriding objective of court proceedings is to deal with cases fairly and justly.Any real or perceived threats to objectivity could undermine the credibility of the evidence provided by the investigator.

This issue poses a particular problem where an audit client requests its auditors to conduct a forensic investigation. In thissituation, the audit firm would be exposed to threats to objectivity in terms of advocacy, management involvement and self-review. The advocacy threat arises because the audit firm may feel pressured into promoting the interests and point of viewof their client, which would breach the overriding issue of objectivity in court proceedings. Secondly, the investigators couldbe perceived to be involved in management decisions regarding the implications of the fraud, especially where the investigatoracts as an expert witness. It is however the self-review threat that would be the most significant threat to objectivity. The self-review threat arises because the investigation is likely to involve the estimation of an amount (i.e. the loss), which could bematerial to the financial statements.

For the reasons outlined above, The Code states that the firm should evaluate threats and put appropriate safeguards in place,and if safeguards cannot reduce the threats to an acceptable level, then the firm cannot provide both the audit service andthe forensic investigation.

Professional competence and due careForensic investigations will involve very specialist skills, which accountants are unlikely to possess without extensive training.Such skills would include:

– Detailed knowledge of the relevant legal framework surrounding fraud,– An understanding of how to gather specialist evidence, – Skills in the safe custody of evidence, including maintaining a clear ‘chain’ of evidence, and– Strong personal skills in, for example, interview techniques, presentation of material at court, and tactful dealing with

difficult and stressful situations.

It is therefore essential that forensic work is only ever undertaken by highly skilled individuals, under the direction andsupervision of an experienced fraud investigator. Any doubt over the competence of the investigation team could severelyundermine the credibility of the evidence presented at court.

ConfidentialityNormally accountants should not disclose information without the explicit consent of their client. However, during legalproceedings arising from a fraud investigation, the court will require the investigator to reveal information discovered duringthe investigation. There is an overriding requirement for the investigator to disclose all of the information deemed necessaryby the court.

Outside of the court, the investigator must ensure faultless confidentiality, especially because much of the information theyhave access to will be highly sensitive.

Professional behaviourFraud investigations can become a matter of public interest, and much media attention is often focused on the work of theforensic investigator. A highly professional attitude must be displayed at all times, in order to avoid damage to the reputationof the firm, and of the profession. Any lapse in professional behaviour could also undermine the integrity of the forensicevidence, and of the credibility of the investigator, especially when acting in the capacity of expert witness.

During legal proceedings, the forensic investigator may be involved in discussions with both sides in the court case, and hereit is essential that a courteous and considerate attitude is presented to all parties.

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3 Poppy Ltd

(a) Balances held at fair value are frequently recognised as material items in the balance sheet. Sometimes it is required by thefinancial reporting framework that the measurement of an asset or liability is at fair value, e.g. certain categories of financialinstruments, whereas it is sometimes the entity’s choice to measure an item using a fair value model rather than a cost model,e.g. properties. It is certainly the case that many of these balances will be material, meaning that the auditor must obtainsufficient appropriate evidence that the fair value measurement is in accordance with the requirements of financial reportingstandards. ISA 545 (UK and Ireland) Auditing fair value measurements and disclosures contains guidance in this area.

As part of the understanding of the entity and its environment, the auditor should gain an insight into balances that are statedat fair value, and then assess the impact of this on the audit strategy. This will include an evaluation of the risk associatedwith the balance(s) recognised at fair value.

Audit risk comprises three elements; each is discussed below in the context of whether material balances shown at fair valuewill lead to increased risk for the auditor.

Inherent riskMany measurements based on estimates, including fair value measurements, are inherently imprecise and subjective innature. The fair value assessment is likely to involve significant judgments, e.g. regarding market conditions, the timing ofcash flows, or the future intentions of the entity. In addition, there may be a deliberate attempt by management to manipulatethe fair value to achieve a desired aim within the financial statements, in other words to attempt some kind of windowdressing.

Many fair value estimation models are complicated, e.g. discounted cash flow techniques, or the actuarial calculations usedto determine the value of a pension fund. Any complicated calculations are relatively high risk, as difficult valuation techniquesare simply more likely to contain errors than simple valuation techniques. However, there will be some items shown at fairvalue which have a low inherent risk, because the measurement of fair value may be relatively straightforward, e.g. assetsthat are regularly bought and sold on open markets that provide readily available and reliable information on the market pricesat which actual exchanges occur.

In addition to the complexities discussed above, some fair value measurement techniques will contain significantassumptions, e.g. the most appropriate discount factor to use, or judgments over the future use of an asset. Managementmay not always have sufficient experience and knowledge in making these judgments.

Thus the auditor should approach some balances recognised at fair value as having a relatively high inherent risk, as theirsubjective and complex nature means that the balance is prone to contain an error. However, the auditor should not justassume that all fair value items contain high inherent risk – each balance recognised at fair value should be assessed for itsindividual level of risk.

Control riskThe risk that the entity’s internal monitoring system fails to prevent and detect valuation errors needs to be assessed as partof overall audit risk assessment. One problem is that the fair value assessment is likely to be performed once a year, outsidethe normal accounting and management systems, especially where the valuation is performed by an external specialist.Therefore, as a non-routine event, the assessment of fair value is likely not to have the same level of monitoring or controlsas a day-to-day business transaction.

However, due to the material impact of fair values on the balance sheet, and in some circumstances on profit, managementmay have made great effort to ensure that the assessment is highly monitored and controlled. It therefore could be the casethat there is extremely low control risk associated with the recognition of fair values.

Detection riskThe auditor should minimise detection risk via thorough planning and execution of audit procedures. The audit team maylack experience in dealing with the fair value in question, and so would be unlikely to detect errors in the valuation techniquesused. Over-reliance on an external specialist could also lead to errors not being found.

ConclusionIt is true that the increasing recognition of items measured at fair value will in many cases cause the auditor to assess theaudit risk associated with the balance as high. However, it should not be assumed that every fair value item will be likely tocontain a material misstatement. The auditor must be careful to identify and respond to the level of risk for fair value itemson an individual basis, to ensure that sufficient and appropriate evidence is gathered, thus reducing the audit risk to anacceptable level.

(b) (i) Enquiries in respect of the external valuer.Enquiries would need to be made for two main reasons, firstly to determine the competence, and secondly the objectivityof the valuer. ISA 620 (UK and Ireland) Using the work of an expert contains guidance in this area.

CompetenceEnquiries could include:– Is the valuer a member of a recognised professional body, for example a nationally or internationally recognised

institute of registered surveyors? (e.g. the Royal Institute of Chartered Surveyors).– Does the valuer possess any necessary licence to carry out valuations for companies?– How long has the valuer been a member of the recognised body, or how long has the valuer been licensed under

that body?

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– How much experience does the valuer have of providing valuations of the particular type of investment propertiesheld by Poppy Ltd?

– Does the valuer have specific experience of evaluating properties for the purpose of including their fair value withinthe financial statements?

– Is there any evidence of the reputation of the valuer, e.g. professional references, recommendations from othercompanies for which a valuation service has been provided?

– How much experience, if any, does the valuer have with Poppy Ltd?

Using the above enquiries, the auditor is trying to form an opinion as to the relevance and reliability of the valuationprovided. ISA 500 (UK and Ireland) Audit evidence requires that the auditor gathers evidence that is both sufficient andappropriate. The auditor needs to ensure that the fair values provided by the valuer for inclusion in the financialstatements have been arrived at using appropriate knowledge and skill which should be evidenced by the valuer beinga member of a professional body, and, if necessary, holding a licence under that body.

It is important that the fair values have been arrived at using methods allowed under SSAP 19 Accounting for investmentproperties. If this has not happened then the value recognised in balance sheet may not be in accordance with financialreporting standards. Thus it is important to understand whether the valuer has experience specifically in providingvaluations that comply with SSAP 19, and how many times the valuer has appraised properties similar to those ownedby Poppy Ltd.

In gauging the reliability of the fair value, the auditor may wish to consider how Poppy Ltd decided to appoint thisparticular valuer, e.g. on the basis of a recommendation or after receiving references from companies for whichvaluations had previously been provided.

It will also be important to consider how familiar the valuer is with Poppy Ltd’s business and environment, as a way toassess the reliability of any assumptions used in the valuation technique.

ObjectivityEnquiries could include:

– Does the valuer have any financial interest in Poppy Ltd, e.g. shares held directly or indirectly in the company?– Does the valuer have any personal relationship with any director or employee of Poppy Ltd?– Is the fee paid for the valuation service reasonable and a fair, market based price?

With these enquiries the auditor is gaining assurance that the valuer will perform the valuation from an independentpoint of view. If the valuer had a financial interest in Poppy Ltd, there would be incentive to manipulate the valuationin a way best suited to the financial statements of the company. Equally if the valuer had a personal relationship witha senior member of staff at Poppy Ltd, the valuer may feel pressured to give a favourable opinion on the valuation of theproperties.

The level of fee paid is important. It should be commensurate with the market rate paid for this type of valuation. If thevaluer was paid in excess of what might be considered a normal fee, it could indicate that the valuer was encouraged,or even bribed, to provide a favourable valuation.

(ii) Additional audit procedures

Audit procedures should focus on the appraisal of the work of the expert valuer. Procedures could include the following:

– Inspection of the written instructions provided by Poppy Ltd to the valuer, which should include matters such asthe objective and scope of the valuer’s work, the extent of the valuer’s access to relevant records and files, andclarification of the intended use by the auditor of their work.

– Evaluation, using the valuation report, that any assumptions used by the valuer are in line with the auditor’sknowledge and understanding of Poppy Ltd. Any documentation supporting assumptions used by the valuer shouldbe reviewed for consistency with the auditor’s business understanding, and also for consistency with any otheraudit evidence.

– Assessment of the methodology used to arrive at the fair value and confirmation that the method is consistent withthat required by SSAP 19 i.e. open market value.

– The auditor should confirm, using the valuation report, that a consistent method has been used to value eachproperty.

– It should also be confirmed that the date of the valuation report is reasonably close to the year end of Poppy Ltd.

– Physical inspection of the investment properties to determine the physical condition of the properties supports thevaluation.

– Inspect the purchase documentation of each investment property to ascertain the cost of each building. As theproperties were acquired during this accounting period, it would be reasonable to expect that the fair value at theyear end is not substantially different to the purchase price. Any significant increase or decrease in value shouldalert the auditor to possible misstatement, and lead to further audit procedures.

– Review forecasts of rental income from the properties – supporting evidence of the valuation.

– Subsequent events should be monitored for any additional evidence provided on the valuation of the properties.For example, the sale of an investment property shortly after the year end may provide additional evidence relatingto the fair value measurement.

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– Obtain a management representation regarding the reasonableness of any significant assumptions, where relevant,to fair value measurements or disclosures.

4 Becker & Co

(a) Joint business arrangementThe business opportunity in respect of Murray Ltd could be lucrative if the market research is to be believed.

However, IFAC’s Code of Ethics for Professional Accountants states that a mutual business arrangement is likely to give riseto self-interest and intimidation threats to independence and objectivity. In addition Ethical Standard 2 (Revised) Financial,business, employment and personal relationships (ES 2) states that an audit firm should not hold any direct financial interestin an audit client. The audit firm must be and be seen to be independent of the audit client, which clearly cannot be the caseif the audit firm and the client are seen to be working together for a mutual financial gain.

In the scenario, two options are available. Firstly, Becker & Co could provide the audit client with finance to complete thedevelopment and take the product to market. There is a general prohibition on audit firms providing finance to their auditclients. This would create a clear financial self-interest threat as the audit firm would be receiving a return on investment fromtheir client. ES 2 states that if a firm should not make a loan (or guarantee a loan) to a client company (unless the audit clientis a bank or similar deposit taking institution, and if the loan is made in the ordinary course of business).

The provision of finance using convertible debentures raises a further ethical problem, because if the debentures are ultimatelyconverted to equity, the audit firm would then hold equity shares in their audit client. This is a severe financial self-interest,for which safeguards are unlikely to be able to reduce to an acceptable level.

The finance should not be advanced to Murray Ltd while the company remains an audit client of Becker & Co.

The second option is for a joint venture company to be established. This would be perceived as a significant mutual businessinterest as Becker & Co and Murray Ltd would be investing together, sharing control and sharing a return on investment inthe form of dividends. Both IFAC’s Code of Ethics and ES 2, state that unless the relationship between the two parties isclearly insignificant, the financial interest is immaterial, and the audit firm is unable to exercise significant influence, then nosafeguards could reduce the threat to an acceptable level. In this case Becker & Co may not enter into the joint venturearrangement while Murray Ltd is still an audit client.

The audit practice may consider that investing in the new electronic product is a commercial strategy that it wishes to pursue,either through loan finance or using a joint venture arrangement. In this case the firm should resign as auditor with immediateeffect in order to eliminate any ethical problem with the business arrangement. The partners should carefully consider if thepotential return on investment will more than compensate for the lost audit fee from Murray Ltd.

The partners should also reflect on whether they want to diversify to such an extent – this investment is unlikely to be in anarea where any of the audit partners have much knowledge or expertise. A thorough commercial evaluation and business riskanalysis must be performed on the new product to ensure that it is a sound business decision for the firm to invest.

The audit partners should also consider how much time they would need to spend on this business development, if theydecided to resign as auditors and to go ahead with the investment. Such a new and important project could mean that theytake their focus off the key business i.e. the audit practice. They should consider if it would be better to spend their time tryingto compete effectively with the two new firms of accountants, trying to retain key clients, and to attract new accounting andaudit clients rather than diversify into something completely different.

(b) Recruitment serviceIFAC’s Code of Ethics for Professional Accountants does not prohibit firms from offering a recruitment service to clientcompanies. However several ethical problems could arise if the service were offered. ES 5 (Revised) Non-audit servicesprovided to audit clients specifies that:

– The audit firm should not provide recruitment services to audit clients that would involve the firm taking responsibilityfor the appointment of any director or employee of the audit client;

– For an audit client that is a listed entity, the audit firm should not provide recruitment services in relation to a keymanagement position of the audit client; and

– The audit firm should not provide advice on the remuneration package for a director or a member of key management.

Specific ethical threats could include:

Self-interest – clearly the motive for Becker & Co to offer this service is to generate income from audit clients, thereby creatinga financial self-interest threat. The amount received for the recruitment service depends on the magnitude of the salary of theperson employed. The more senior the person recruited, the higher their salary is likely to be, and therefore the higher thefee to be paid to Becker & Co.

In addition, the firm could be tempted to advise positively on the recruitment of an individual merely to receive the relevantrecruitment fee, without properly considering the suitability of the person for the role.

Familiarity – when performing the audit, the auditors may be less likely to criticise or challenge the work performed by aperson they helped to recruit, as any significant problems discovered may make the recruitment appear ill-advised.

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Management involvement – there is also a threat that the audit firm could be perceived to be making management decisionsby selecting employees. The firm could offer services such as reviewing the professional qualifications of a number ofapplicants, and providing advice on the applicant’s suitability for the post. In addition the firm could draw up a shortlist ofcandidates for interview, using criteria specified by the client. However in all cases, the final decision as to whom to hire mustbe made by the client, as the audit firm should not make, or be perceived to be making, management decisions.

The threats discussed above would increase in significance if the recruitee took on a role in key management pertaining tothe finance function, such as finance director or financial controller. The threats would be less severe if the audit firm advisedon the recruitment of a junior member of the client’s finance function.

If these threats could not be reduced to a level less than clearly insignificant, then the recruitment service should not beoffered.

Commercial evaluationThe firm should consider whether there is likely to be much demand for the potential service before developing such aresource. Some form of market research is essential.

Offering this type of service represents a significant departure from normal audit services. The firm should consider whetherthere is sufficient knowledge and expertise to offer a recruitment service. Ingrid Sharapova seems to have some experience,but her skills may be out of date, and may not be specifically relevant to the recruitment of finance professionals. It may bethat considerable training and possibly the attainment of a new professional qualification relevant to recruitment may benecessary for a credible service to be offered to clients.

If the recruitment service proved successful, then Ingrid could be faced with too much work as she is the only person withrelevant experience, and has no one to delegate to. If the firm decides to offer this service, then one other person shouldreceive appropriate training, to cover for Ingrid’s holidays and any sick leave, and to provide someone for Ingrid to delegateto. The financial cost of such training should be considered.

Finally, Becker & Co should consider the potential damage to the firm’s reputation if the service offered is not of a high quality.If the partners decide to pursue this business opportunity, they may wish to consider setting it up as a separate entity, so thatif the business fails or its reputation is questioned, the damage to Becker & Co would be minimised.

(c) Temporary staff assignments

ES 2 provides guidance on temporary staff (loan staff) assignments. ES 2 states that an audit firm should not provide a partneror employee to work on a temporary basis for an audit client unless:

– The individual concerned will not hold a management position,– The audit client acknowledges responsibility for directing and supervising the work to be performed, and– The work will not include making management decisions and does not commit the audit client to a particular position

or accounting treatment.– Additionally, when the individual returns to the firm on completion of the loan staff assignment, they should not be given

any role on the audit involving any function or activity that was performed during the assignment.

Lending staff on a temporary basis to an audit client will create the following ethical threats:

Management involvement – Assuming that the manager or senior is seconded to the finance function of the audit client, itis likely that the individual would be in some way involved in decision making in relation to the accounting systems,management accounts or financial statements.

Self-review – Even if the individual were not assigned to the client where they performed a temporary assignment, the auditteam assigned may tend to over rely on areas worked on by a colleague during the period of their temporary assignment.

Familiarity – if the individual is working at the client at any time during the audit, there will be a familiarity threat, wherebyaudit team members will be unlikely to sufficiently challenge, and therefore not exercise enough professional scepticism whendealing with work performed by the seconded individual.

In addition, due to the over-staffing problem of Becker & Co, the seconded individuals may feel that if they were not on thesecondment, they could be made redundant. This may cause them to act in such as way as not to jeopardise the secondment,even if the action were not in the best interests of the firm.

The threats discussed above are increased where a senior person likely to make significant decisions is involved with thetemporary assignment, as in this case where audit managers or seniors will be the subjects of the proposed secondment.

In practice, assistance can be provided to clients, especially in emergency situations, but only on the understanding that thefirm’s personnel will not be involved with:

– Making management decisions,– Approving or signing agreements or similar documents, and – Having the authority to enter into commitments on behalf of the company.

In addition, the individual seconded to a client should not then be involved in any way with the audit of that client when theyreturn to the audit firm. This may be a difficult area, as presumably the client would prefer to have an individual secondedto them who has knowledge and experience of their business, i.e. a member of the audit team, and most likely in this scenarioto be the audit manager. If this were the case the manager would then have to be reassigned to a different client, causinginternal problems for the audit firm. This problem is likely to outweigh any benefits, financial or otherwise, to Becker & Co.

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If the temporary staff assignment were to a non-finance department of the client then the threats would be reduced.

If Becker & Co decides to go ahead with the secondment programme, the firm must ensure that the staff are suitablyexperienced and qualified to carry out the work given to them by the client. There could be a risk to the reputation of Becker& Co if the seconded staff are not competent or do not perform as well as expected by the client.

One advantage of a secondment is that the individual concerned can benefit from exposure to a different type of work andwork environment. This will provide some valuable insights into accounting within a business and the individual may bringsome new skills and ideas back into the audit firm.

However, the staff seconded could be offered a permanent position at the client. This would lead to the loss of key membersof staff, and be detrimental for Becker & Co in the long run.

The other benefit for the audit firm is that a programme of secondments will ease the problem of an over-staffed auditdepartment, and should have cash flow benefits.

Tutorial note: In answering this question it is relevant to briefly mention corporate governance implications i.e. the client maynot be able to accept the services offered by their auditor for ethical, particularly objectivity, reasons.

5 Dexter Ltd

(a) Responsibilities of management and auditors

ResponsibilitiesISA 570 (UK and Ireland) Going concern provides a clear framework for the assessment of the going concern status of anentity, and differentiates between the responsibilities of management and of auditors. Management should assess goingconcern in order to decide on the most appropriate basis for the preparation of the financial statements. FRS 18 Accountingpolicies requires that where there is significant doubt over an entity’s ability to continue as a going concern, the uncertaintiesshould be disclosed in a note to the financial statements. Where the directors intend to cease trading, or have no realisticalternative but to do so, the financial statements should be prepared on a ‘break up’ basis.

Thus the main focus of the management’s assessment of going concern is to ensure that relevant disclosures are made wherenecessary, and that the correct basis of preparation is used.

The auditor’s responsibility is to consider the appropriateness of the management’s use of the going concern assumption inthe preparation of the financial statements and to consider whether there are material uncertainties about the entity’s abilityto continue as a going concern that need to be disclosed in a note.

The auditor should also consider the length of the time period that management have looked at in their assessment of goingconcern.

The auditor will therefore need to come to an opinion as to the going concern status of an entity but the focus of the auditor’sevaluation of going concern is to see whether they agree with the assessment made by the management. Therefore whetherthey agree with the basis of preparation of the financial statements, or the inclusion in a note to the financial statements, asrequired by FRS 18, of any material uncertainty.

Evaluation techniquesIn carrying out the going concern assessment, management will evaluate a wide variety of indicators, including operationaland financial. An entity employing good principles of corporate governance should be carrying out such an assessment aspart of the on-going management of the business.

Auditors will use a similar assessment technique in order to come to their own opinion as to the going concern status of anentity. They will carry out an operational review of the business in order to confirm business understanding, and will conducta financial review as part of analytical procedures. Thus both management and auditors will use similar business riskassessment techniques to discover any threats to the going concern status of the business.

Auditors should not see going concern as a ‘completion issue’, but be alert to issues affecting going concern throughout theaudit. In the same way that management should continually be managing risk (therefore minimising going concern risk),auditors should be continually be alert to going concern problems throughout the duration of the audit.

However, one difference is that when going concern problems are discovered, the auditor is required by IAS 570 to carry outadditional procedures. Examples of such procedures would include:

– Analysing and discussing cash flow, profit and other relevant forecasts with management– Analysing and discussing the entity’s latest available interim financial statements– Reviewing events after the period end to identify those that either mitigate or otherwise affect the entity’s ability to

continue as a going concern, and– Reading minutes of meetings of shareholders, those charged with governance and relevant committees for reference to

financing difficulties.

Management are not explicitly required to gather specific evidence about going concern, but as part of good governance wouldbe likely to investigate and react to problems discovered.

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(b) Directors reluctance to discloseThe directors are likely to have several reasons behind their reluctance to disclose the note as recommended by the auditmanager. The first is that the disclosure of Dexter Ltd’s poor cash flow position and perilous going concern status may reflectbadly on the directors themselves. The company’s shareholders and other stakeholders will be displeased to see the companyin such a poor position, and the directors will be held accountable for the problems. Of course it may not be the case thatthe directors have exercised poor management of the company – the problems could be caused by external influences outsidethe control of the directors. However, it is natural that the directors will not want to highlight the situation in order to protecttheir own position.

Secondly, the note could itself trigger further financial distress for the company. Dexter Ltd is trying to raise finance, and it isprobable that the availability of further finance will be detrimentally affected by the disclosure of the company’s financialproblems. In particular, if the cash flow difficulties are highlighted, providers of finance will consider the company too riskyan investment, and are not likely to make funds available for fear of non-repayment. Existing lenders may seek repayment oftheir funds in fear that the company may be unable in the future to meet repayments.

In addition, the disclosures could cause operational problems, for example, suppliers may curtail trading relationships as theybecome concerned that they will not be paid, or customers may be deterred from purchasing from the company if they feelthat there is no long-term future for the business. Unfortunately the mere disclosure of financial problems can be self-fulfilling,and cause such further problems for the company that it is pushed into non-going concern status.

The directors may also be concerned that if staff were to hear of this they may worry about the future of the company andseek alternative employment, which could lead in turn to the loss of key members of staff. This would be detrimental to thebusiness and trigger further operational problems.

Finally, the reluctance to disclose may be caused by an entirely different reason. The directors could genuinely feel that thecash flow and operational problems faced by the company do not constitute factors affecting the going concern status. Theymay be confident that although a final decision has not been made regarding financing, the finance is likely to be forthcoming,and therefore there is no long-term material uncertainty over the future of the company. However audit working papersconclude that there is a significant level of doubt over the going concern status of Dexter Ltd, and therefore it seems that thedirectors may be over optimistic if they feel that there is no significant doubt to be disclosed in the financial statements.

(c) (i) Audit report implications

Audit procedures have shown that there is a significant level of doubt over Dexter Ltd’s going concern status. FRS 18requires that disclosure is made in the financial statements regarding material uncertainties which may cast significantdoubt on the ability of the entity to continue as a going concern. If the directors refuse to disclose the note to the financialstatements, there is a clear breach of financial reporting standards.

In this case the significant uncertainty is caused by not knowing the extent of the future availability of finance neededto fund operating activities. If the note describing this uncertainty is not provided, the financial statements are not fairlypresented.

The audit report should contain a qualified or an adverse opinion due to the disagreement. The auditors need to makea decision as to the significance of the non-disclosure. If it is decided that without the note the financial statements arenot fairly presented, and could be considered misleading, an adverse opinion should be expressed. Alternatively, it couldbe decided that the lack of the note is material, but not pervasive to the financial statements, then a qualified ‘exceptfor’ opinion should be expressed.

ISA 570 (UK and Ireland) Going Concern and ISA 700 (UK and Ireland) The Auditor’s report on financial statementsprovide guidance on the presentation of the audit report in the case of a modification. In both cases, the audit reportshould include a paragraph which contains specific reference to the fact that there is a material uncertainty that maycast significant doubt about the entity’s ability to continue as a going concern. The paragraph should include a cleardescription of the uncertainties and would normally be presented immediately before the opinion paragraph.

(ii) If the directors agree to disclose the note, it should be reviewed by the auditors to ensure that it is sufficiently detailed.In evaluating the adequacy of the disclosure in the note, the auditor should consider whether the disclosure explicitlydraws the reader’s attention to the possibility that the entity may not be able to continue as a going concern in theforeseeable future. The note should include a description of conditions giving rise to significant doubt, and the directors’plans to deal with the conditions. If the note provided contains adequate information then there is no breach of financialreporting standards, and so no disagreement with the directors.

If the disclosure is considered adequate, then the opinion should not be qualified. The auditors should consider amodification by adding an emphasis of matter paragraph to highlight the existence of the material uncertainties, and todraw attention to the note to the financial statements. The emphasis of matter paragraph should firstly contain a briefdescription of the uncertainties, and also refer explicitly to the note to the financial statements where the situation hasbeen fully described. The emphasis of matter paragraph should re-iterate that the audit opinion is not qualified.

However, it could be the case that a note has been given in the financial statements, but that the details are inadequateand do not fully explain the significant uncertainties affecting the going concern status of the company. In this situationthe auditors should express a qualified opinion, disagreeing with the preparation of the financial statements, as thedisclosure requirements of FRS 18 have not been followed.

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Professional Level – Options Module, Paper P7 (UK)Advanced Audit and Assurance (United Kingdom) December 2008 Marking Scheme

Marks1 (a) Financial Statement Risks

Generally 1/2 mark each risk/matter identified.1/2 mark for reference to correct SSAP/FRS – maximum 2 marks.Maximum 2 marks for materiality calculations.

Up to maximum marks for each significant issue explained as below:

– Revenue recognition (2 marks + 1 mark for providing calculation/trend) FRS 5– Share-based payment (3 marks) FRS 20– Provision for repairs (2 marks) FRS 12– Insurance reimbursement (1 mark) – Understatement of operating expenses (2 marks)– Impairment of properties (1 mark) FRS 11– Property disposals (31/2 marks) FRS 5 and FRS3– Property revaluation (11/2 marks) FRS 15– Deferred tax on property revaluation (11/2 marks) FRS 19– Deferred tax asset (2 marks + 1 mark for recalculating profit for any suggested changes) FRS 19– Going concern (1 mark)

Maximum marks 14

(b) (i) Audit procedures

Generally 1 mark per procedure:

– Agree components of calculation to scheme documentation (1/2 mark per item agreed, max 2)– Recalculate + check vesting period– Agreement of grant date, fair values, etc to specialist report– Review of forecast staffing levels– Management representation– Discussion with HR re assumptions used

Maximum marks 6

(ii) Audit procedures

Generally 1 mark per procedure:

– Obtain client tax comp + deferred tax schedules, recalculate– Form independent estimate of amount– Profitability forecasts – assumptions– Profitability forecast – time period for losses to be utilised– Tax authority agreement on c/f of losses

Maximum marks 4

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Marks(c) Social and environmental KPIs

Up to 2 professional marks for format, logical structure and use of language appropriate to internalauditor. Tabular format not required.

Generally 1/2 mark per KPI, 1/2 mark per evidence point.

Ideas listEmployees:– Training spend– Absenteeism rates– Employee engagement indexCustomers– Customer satisfaction rate– Number of complaints– Number of accidents– Repeat business ratesCommunity– Charitable donations– Free use of hotel facilitiesEnvironment– Waste recycling– Energy efficient items purchased– Carbon footprint

Maximum marks 10–––

Total 34–––

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Marks2 (a) Definitions – 2 marks per definition (general principle rather than exact wording, examples can be

used to illustrate definition)

Maximum marks 6

(b) Report on aims and method of conducting a forensic accounting investigation

Up to 3 marks for use of professional business English, language appropriate to client and tofinance director (i.e. not patronising), tactful (i.e does not criticise client)

Up to 11/2 marks per comment:

– Introduction referring to reason behind the report and to clarify contents (1 mark)– Aim – clarify fraud taken place– Aim – discover the perpetrator(s)– Aim – prosecute the perpetrator(s)– Aim – quantify losses– Method – consider type of fraud – ghost employee– Method – understand how it could have taken place – controls override– Method – collect evidence – sufficient and relevant – allow up to 2 extra marks here if

examples given of procedures that could be performed – Method – interview suspect– Method – produce reports– Expert witness– Advice and recommendations to prevent another fraud

Maximum marks 14

(c) Professional ethics – application of fundamental principles

Up to 11/2 marks per comment:

– Integrity (max 1 mark)– Objectivity (max 3 marks)– Professional competence and due care– Confidentiality– Professional behaviour

1 mark for recognition that principles apply to all professional engagements

Maximum marks 6–––

Total 26–––

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Marks3 (a) Discuss whether recognition of fair values leads to increased audit risk

Generally one mark per point:

– Introduction referring to widespread need to recognise fair values due to financial reporting standard requirements– Example of item recognised at fair value (other than investment property)– Discussion of inherent risk – subjectivity– Discussion of inherent risk – deliberate manipulation– Discussion of inherent risk – complexity– Discussion of control risk – non routine transactions– BUT may lead to increased level of monitoring– Discussion of detection risk– Conclusion1/2 mark for reference to ISA 545.Maximum 1 mark for definitions of fair value/audit risk.

Cap marks at 5 if no attempt is made to produce a rounded discussion (i.e. should not assumethat fair value automatically increases audit risk)

Maximum marks 7

(b) (i) Enquiries regarding valuer

Generally 1 mark per enquiry:

– Membership of professional body– Whether a licence is held– Reputation – references, etc– Experience with Poppy Ltd’s type of property– Experience with preparing valuations under SSAP 19 i.e. open market value– Financial interest– Personal interest1/2 mark for reference to ISA 620

Up to 4 marks for assessment of reliabilty, up to 2 marks for assessment of objectivity.

Maximum marks 7

(ii) Audit procedures

Generally 1 mark per procedure from ideas list:

– Review written instructions– Evaluate assumptions– Check consistent method used– Check date of report close to year end– Method to follow SSAP 19 market value framework– Physical inspection – Review of purchase documentation– Subsequent events– Management representation

Maximum marks 6–––

Total 20–––

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Marks4 (a) Joint business arrangement

Generally 1–11/2 marks per comment:

– Self-interest independence threats:– Loans to clients generally prohibited– Convertible loan stock would lead to equity stake in client – prohibited– Joint venture arrangement is significant business interest– Audit firm would share control of Joint Venture with audit client– Finance involved likely to be significant

– Can only proceed with business venture if resign as auditors– Potentially lucrative business opportunity BUT– Auditors lack commercial experience in this type of venture– Should spend time on client retention and attraction

Maximum marks 7

(b) Recruitment service

Generally 1–11/2 marks per comment:

– Explanation of self-interest threat– Explanation of familiarity threat– Explanation of management involvement threat– Threats increase with seniority of recruitee– Can look at CVs and draw up shortlist but management to take final decision– Ingrid lacks specific, recent experience– May not be much demand for the service– Need to train second person – cost implication– Consider setting up as separate business

Maximum marks 7

(c) Temporary staff assignment

Generally 1–11/2 marks per comment:

– Explanation of self-review threat– Explanation of management involvement threat– Explanation of familiarity threat– Description of safeguards– Problem when secondee returns to audit firm – reassign to other client– Individual benefits from different work experience…– But may be offered permanent employment by the client– Issues with competence of people seconded– Eases audit firm’s over-staffing problem

Maximum marks 6–––

Total 20–––

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Marks5 (a) Compare and contrast management and auditors’ responsibilities regarding going concern

1/2 mark ref FRS 18, 1/2 mark ref ISA 570Generally 1 mark per explained point.

Maximum mark to be capped at 4 where no attempt made to explain similarities or differences.

Maximum marks 7

(b) Reluctance to disclose note

Generally 1 mark per comment:

– Directors fear they will be held accountable for problems– Trigger further financial distress as necessary finance is withheld– Trigger operational distress due to reactions of suppliers and customers– Trigger operational problems if key members of staff leave– Directors may genuinely feel that the financial and operating problems do not impact on

going concern status

Maximum marks 5

(c) (i) Audit report implication – note not provided

Generally 1 mark per comment:

– Breach of FRS 18 leading to disagreement– Opinion could be qualified or adverse– Judgement needed– Report to refer to material uncertainty

Maximum marks 4

(ii) Audit report implication – note provided

Generally 1 mark per comment and 1/2 mark ref ISA 700

– Review adequacy of disclosure– If note is sufficient – no breach of financial reporting standards – unqualified opinion– Emphasis of matter paragraph to highlight uncertainties– If note inadequate – qualify ‘except for’ disagreement

Maximum marks 4–––

Total 20–––

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Management Auditors

Focus is to follow FRS 18 requirements regardingdisclosure of going concern problems or toprepare on break up basis.

Focus is to form independent opinion on goingconcern status and to see if FRS 18requirements adhered to.

Range of indicators assessed Range of indicators assessed

No requirement to perform specific procedures ISA 570 requires specific proceduresISA 570 requires assessment period used bymanagement

Should be part of on going management of thebusiness

Going concern should be considered throughoutthe audit